The Three Keys to Successful Retirement Investing, Part 2


BikeAs stated in the last post, successful investing in retirement really comes down to fundamental principles more than finding the right mutual fund.  Utilize these principles to drive your decisions and you’ll be successful.  I’ll call these the Three keys to retirement investing.    These are:

  1. Contribute early and regularly
  2. Take appropriate risks
  3. Delay withdrawals as long as possible

In this series of posts, we’ll look at each of these keys and why they are important.  Today we’ll look the second key, how to take risks appropriate for you investment horizon and personal risk tolerance.

Key #2: Take appropriate risks

The first aspect of investment risk is volatility.  Let’s start there.

Volatility

Most of the time when people talk about investment risk, they are talking about volatility.  This is how rapidly the value of your investment changes. In other words, how much of your money you can lose in a relatively short period of time.  Things that are volatile like individual stocks can go up or down in price by 50% easily within a year, and can sometimes do so within a period of a few days or weeks.  In fact, stocks tend to make fast moves in one direction or another as news breaks, followed by a period where they change in price little.

Volatility is often measured by the term, beta, which can be thought of as the volatility of an investment compared to the whole market.  Stocks that have a beta of 1.0 have a volatility level equal to that of the market.  Those with a beta of 2.0 have twice the volatility of the market.   High beta stocks move up and down more than low beta stocks.

Investments that are more volatile are considered to carry more risk than those that are less volatile because their return is less predictable.  If you put $100 in a bank CD yielding 1% per year, you’ll know that it will be worth $101 in a year.  If you invest $100 in a stock index fund, it might be worth $140 in a year, or $60 in a year, or anything in between.  Stocks are very volatile when compared to bank CDs.  Because volatile investments have more risk, you want to only buy them if your potential for reward is greater.  If you can get an assured 1% in a bank CD, why would you buy a stick if the potential return were the same?  Maybe you would want to get a 50% gain from an individual stock when things work out to make up for the times when they don’t.  Let’s say that four times out of five your return is 0%, where it is 50% the other time.  By buying many stocks, you can then nearly assure yourself of getting an average 10% return overall if you can get a 50% gain when things go your way.  If the gain in stocks was only 5% when successful, you would be making the same return as you could with the bank, so it would not be worth the risk.

The return you receive is based on the price you pay when you invest.  If you’re buying an  individual stock, you need to pay a low enough price so that when earnings come in and meet expectations, the value of the stock will move up enough to give you the 50% return you desire (just to use the numbers we’ve been using).  Luckily for you, while there are some random fluctuations in price, on average stocks (and other investments) will already be priced appropriately for their risk levels due to the behavior of the market.   If you buy at several different times, as opposed to simply dumping your money in all at once, the random fluctuations will smooth themselves out and you’ll pay a price that is appropriate for the risk.  Over long periods of time, the average return on a portfolio containing a large number of stocks has ranged from about 10 to 15% per year.  This is significantly better than the returns of bonds (which range from 5-10%) and bank investments (which range from 0-5%).

So in summary, higher volatility leads to higher returns, but high volatility can also cause losses.   The trick is to use two other factors, diversification and time, to manage that risk and make it so that you are almost guaranteed to make a great return.  Let’s look at each of those aspects.

Diversification

Diversification, where you invest in more than one thing,  reduces volatility risk.  If five stocks are moving randomly, if you buy shares in all five the movements up in some will cancel out the movements down in the others most of the time since the movements are random.  This is the same as throwing a hand full of coins – you don’t know which ones will be heads and which will be tails, but you know that the result will be somewhere between 30 and 70% heads a lot more often than it will be between 90 and 100% heads or 90 to 100% tails simply because there are a lot more combinations in the 30-70% heads range than there are at either extreme.   Because the average price for stocks has a natural tendency to increase (because companies become more efficient and grow, and make more money), if you buy a group of stocks the random fluctuations in the value of the group will cancel but the overall average value will increase.

The other form of risk that diversification eliminates is the risk of bad management or random events.  If you just buy Coke stock and the Coke CEO makes a bad decision (like introducing New Coke in the 1980’s), you could see the value of your investment crater even though people are still drinking soft drinks and cola stocks, in general, are doing well.  If you buy stock in both Coke and Pepsi, however, while one of the companies may make a bad decision and cause their stock to drop significantly, it is unlikely that both will do so at the same time.  In fact, a misstep by one might provide an opportunity for the other.  It is even better if you buy shares in different industries since then you eliminate the risk of a downturn in a specific industry.  If you buy Coke and Pepsi, plus shares in a bank, and shares in a medical device supplier, while one industry may go through a rough patch where all of the companies in that industry decline, it is unlikely that three different industries would hit trouble at the same time.

It is even better if you buy shares in different industries since then you eliminate the risk of a downturn in a specific industry.  If you buy Coke and Pepsi, plus shares in a bank, and shares in a medical device supplier, while one industry may go through a rough patch where all of the companies in that industry decline, it is unlikely that three different industries would hit trouble at the same time.  The easiest way to add diversification is to buy mutual funds, index funds, or ETFs, all of which allow you to make one investment but get investments in a large number of assets.  If you buy shares in an S&P500 index fund, for example, you’ll be invested in 500 large US companies. but at a cost far lower than it would be to actually buy shares in all 500 companies.  In 401k accounts, mutual funds and index funds are normally the only choices.

There will also be times when an entire market declines.  For example, investors may be worried about an election and decide to sell their shares in US stocks.  In this case, shares of all US stocks may decline – both the good and the bad.    Note this is really the time to buy more shares since they are effectively on sale, but if you have money invested that you need soon, you may not be able to wait for prices to recover.  To guard against this risk, you can diversify into more than one type of asset.  For example, buying both stocks and bonds, or buying both US and international stocks.  In general, you try to find investments that aren’t tied to each other so that they don’t move together.  This can be difficult, but having investments in stocks, bonds, and REITs is not a bad combination, in part because the interest payments and rental income paid by bonds and REITs, respectively, help to keep them from declining in price as much as stocks when the market declines.  Of course, for short-term needs (like within five years), cash is the appropriate investment.

Time

Time frame is often forgotten when looking at risk.  Time frame will also reduce risk since you don’t need to be right about the timing for an investment to do well if you have a lot of time to wait, you just need to wait until things start to happen.  If you have a lot of time, you can reduce your diversification (but not eliminate it since single stocks or bonds can disappear entirely), since you can just wait out a market downturn or wait for the product lines of the companies you’re investing in to catch on.  In general:

Risk is proportional to:    (volatility)/(diversification x time)

More volatility causes more risk, but time and diversification both reduce risk.  In addition to reducing risk, however, diversification reduces your reward potential.   When looking at buying single stocks, adding more investments means some won’t perform as well as others.  If you just buy Coke and Coke increases in share price by 100%, you’ll do better than if you buy both Coke and Pepsi and Coke goes up 100% but Pepsi only goes up by 10% over the same period.  Diversifying into other markets also reduces your potential reward.   Because lower volatility investments like bonds don’t provide the same long-term return as higher volatility investments like stocks, diversifying into bonds will reduce the level of fluctuations in your overall portfolio value but also reduce your long-term return.

It is, therefore, better to use time to reduce risk than diversification if you have time available.  If you can stay invested for a long period of time and can just wait out market declines, it is better to hold more stocks than bonds.  As you get closer to needing the money, you then add diversification closer to equal percentages of growth investments like stocks and income investments like bonds to reduce risk since you no longer have the luxury of time.

Using appropriate risk

So to use appropriate risk when investing in a retirement account, do the following:

  1.  When you don’t need the money for a long period of time (like 20 years), concentrate more in higher volatility assets like stocks since they have a higher return.  A rule-of-thumb is to put your age minus 10% in income assets like bonds and the rest in growth assets like stocks.
  2. If volatility scares you, add more income assets that will reduce volatility (and don’t look at your portfolio value too often – a couple of times per year is fine).
  3. When you start to get close to the time when you’ll need the money, add lower volatility assets like bonds and REITs that pay out cash and have a more stability.
  4. Assume that your stocks may be up or down 20% in five years (and 50% in one year) and that your bonds may be up or down 10% in five years (and 15% in one year) and decide if you can take that risk.  For money you really, really need to have within five years, go to cash assets like bank CDs and money market funds since those are the only things that don’t go down in value.

 

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The Three Keys to Successful Retirement Investing


BikeSuccessful investing in retirement really comes down to fundamental principles more that it is about finding the right mutual fund.  Utilize these principles to drive your decisions and you’ll be successful.  I’ll call these the Three keys to Retirement Investing.    These are:

  1. Contribute early and regularly
  2. Take appropriate risks
  3. Delay withdrawals as long as possible

Over the next few posts, we’ll look at each of these keys and why they are important.  Today we’ll look at the importance of contributing early and regularly.

Contribute Early and Regularly

Let’s look at one individual who contributes $500 per month to his/her 401k, starting at age 25, which is $6,000 per year.  This is about the level of contributions that someone making $40,000-$60,000 per year in salary should be striving to make.  Assuming they receive an annual percentage yield of 12% over the 40 years they are invested, their portfolio would grow something like this:

Age 25, 12% APR until age 65
Age 25, 12% APR until age 65

Now, understand that he/she would not see steady growth like this in the stock market.  It would be ups and downs, with some years that make 50% and others that lose 30%.  Assuming that a 12% APR was realized, however, the net effect would be the same: a retirement portfolio in the $5M to $10M range.   Here, our investor only contributed $240,000 of the money over his working lifetime.

Now let’s assume our investor waited until age 45 to start investing, then put away $2,000 per month for the next 20 years, trying to make up for lost ground.  His/her return would look like this:

 

45investor
Age 45, 12% APR until age 65

Here our investor has invested $480,000, but only ends up with about $1.2 M in retirement funds.  By starting early, our first worker invested half as much, but ended up with about five to seven times more.

Now, what about making regular contributions?  Efficient market theory says:

“Everything known is priced into the markets instantly, leaving only random fluctuations when there is no news.”

This means that the price of stocks (and bonds, and other investments) includes all news and what is known at this moment.   You may hear that Apple is coming out with a new iPhone and think it is a great time to load up on shares of Apple.  The trouble is that everyone else has heard the same news and before you can push “buy” on your screen, the price of the shares have already risen.

Other price movements not connected to news are therefore just random, unpredictable noise.   You might think that stocks are pricey since they’ve gone through a big run up, but that doesn’t mean that they won’t continue to go up for a while.  Maybe great earnings will come in and suddenly the higher price of the shares will be justified.  If you try to buy and sell stocks because you’re trying to time the markets, you’ll be right about 50% of the time since really you’re betting on a coin flip.  the other 50% of the time you’ll be wrong.

The trouble is, most of the big market moves – the ones that result in returns of 12% per year averaged over many years – occur during really short periods of time.  A big rally may last only a couple of weeks or even a couple of days.  Miss out on a few of these big rallies, and you’ll earn 2% instead of 12%.

Buying in has the same issue.  If you just dump a bunch of money in the stock market and walk away, you are just as likely to be buying in at a high point as a low point.  Pick the wrong high point, like 1999, 2007, or 1929, and you can be waiting years before you get back to even.  Instead, you want to be making regular contributions, whether you think the markets are pricey or cheap.  That way you’ll be buying shares as they dip in price.  Even if you buy during a period in which the markets are flat, your average buy price will be lower than the average market price because you’ll be buying more shares when they are lower in price than when they are higher.

 

Next time I’ll talk about risk and taking appropriate risks, given your time until retirement and other factors.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to Get Started with Mutual Fund Investing


FireAlarmMutual fund investing requires the least amount of effort and knowledge when it comes to investing.  With single stock investing you need to research stocks, learn how to put in different types of orders, track price movements periodically to find stocks that have gone south or that have grown too much, and spend time on taxes each year entering your capital gains.  With mutual funds, you just need to spend an hour or two once finding funds that meet your needs, then send in a check periodically.  The goal of this post is to give most of the information you need to know to start investing in mutual funds.

 

What are stock and bonds?

Stocks are ownership stakes in corporations.  You actually are buying a part of the company in which you’re investing.  If the company does well and starts making more money, the value of your part of the company normally increases.  Once a company gets large enough that they don’t need all of their income for expansion and growth, often they will start giving you a portion of the profits they make in what is called a dividend.

A bond is a loan to a company (or a city, federal government, etc…).  In exchange, they agree to pay you interest for a certain period of time, and then give you your money back at the end.  (This is assuming that you bought the bond directly from the company.  If you bought the bond from someone else, you get paid whatever the first person who bought the bond paid the company.  This is called the par value and is normally $1,000 per bond for corporate bonds.)  The price of a bond will depend on interest rates at the time, how long it is until the loan is to be repaid, and how likely people think the company is to repay the loan.

What are mutual funds?

Mutual funds are collections of stocks, bonds, or other investments.  When you buy into a mutual fund, you are giving money to a manager who then invests the money for you.  Your money is pooled with that of many other people, such that you can own a small amount of a lot of different companies and investments.  This would be impossible investing on your own outside of a fund since it would cost way too much to buy that many different stocks unless you had a lot of money to invest (several million dollars).  The main reason for buying mutual funds is to get diversification, which is where you spread your money out to several different investments.  This reduces your risk of taking a large loss due to a significant event at a single company since each company only makes up a small amount of the fund and there are other companies that will generally do well during the same period.  Think of it this way – if you buy one home without insurance, you run the risk of a fire causing you to lose your whole investment.  If you buy homes all over the country, one fire would only cause a small percentage loss.

What are the risks of buying mutual funds?

Mutual funds are not like a bank account.  There is no guarantee that you will get a specific return on your investment or even get all of your money back.  They are safer than individual stocks and bonds, but there is still investment risk.  Another risk is not that the fund will actually lose value, but that it will not go anywhere for a significant period of time, meaning you would have done better putting your money into a bank CD.

If they’re so risky, why buy them?

If you include inflation, your savings in a bank account will actually decrease with time.  A dollar fifty years ago would buy what $100 does now. Because the value of companies increases (in dollar terms) with inflation, you really need to invest money that you will not be using in the next few years.

Beyond inflation, because companies are growing and expanding, their stock will become more valuable over time.  If you buy a whole set of stocks (as with a mutual fund), some companies may fail or go nowhere, but the ones that do well will make up for the others and then some.  While there are no guarantees, over most long periods of time, like 10-20 years, stocks have returned between about 10 and 20% per year.  This is way better than bank returns.  So long as nothing happens to cause the entire economy to collapse, mutual funds should offer much better returns than bank accounts in the future.  This gives the average worker a way to retire with a great deal of money without actually saving up all of the money.

How do I buy mutual funds?

The easiest way to buy funds is to go to the website for one of the fund companies (Vanguard, Fidelity, Janus, etc…), start an account, and then send in a check or transfer funds electronically from your bank account.  Probably my favorite family of funds is Vanguard, but there are many others.  Most funds have minimum investments, between $3,000 and $5,000.  Some companies allow smaller amounts to start if it is for a retirement account and/or you allow automated future investments from your account.  Note that because the fund companies will probably lose money on your account when you have little invested since their costs to send statements and handle your transactions will be more than they’ll be charging you in fees, they will want you to grow your investments as quickly as possible.

How do I select which funds to buy?

The company should have the funds available on their investing website.  Each of the funds will have a document called a prospectus that tells about the fund.  The most important things to you will be their investment objectives and their fees.

You can tell generally what the investment objectives are from their name normally, but an objective statement should be the first thing in the prospectus.  Read this statement to understand what the fund does.  What sort of things do they invest in?  Are they a managed fund, where a manager picks the investments, or are they an index fund that tries to match the returns of a specific index?  Do they buy stocks, bonds, or a mixture?

You’ll want to have a mixture of funds that invest in different areas of the markets.  A large-cap fund such as an S&P500 fund is a good first fund, as is a small Cap Fund such as the Nasdaq QQQ fund.  You can also just buy a total stock market fund that basically invests in everything.   If you will need the money in the next  ten to fifteen years, or if you just want to the value of your portfolio to be a bit less volatile, you can add a bond fund to the mix.  A rule-of-thumb if you’re investing for retirement is to “invest your age minus ten percent” in bonds, meaning if you’re 50, you’ll be 40% in bonds and 60% in stocks.  In general, the larger the percentage of bonds you have, the less volatile your portfolio will be, but the lower your return will be over long periods of time.  In down markets, bonds tend to not decline as much as stocks.  In up markets, however, they won’t go up as much either.

Rather than dumping all of your money in at once, it is a good idea to buy regularly over time.  If you invest fixed amounts regularly you’ll get a better price since you’ll buy more shares when the funds dip and price and less when they rise.  This is easy if you’re saving up and investing as you go.  Just add more money each time you save up a five hundred to a thousand dollars or so.  If you have a lot to start with, invest it over a year or two, perhaps buying more each time the market dips, but still buying even when the market is rising since there can be some runs that go for a long time.

On the fees, the prospectus will generally give the fees and expenses as a percentage of investment value, plus a table showing how much in fees would be paid over a 5 or 10 year period if you owned the fund.  You generally want fees to be less than 1% of assets.  0.25% of assets or lower is very good.  Unmanaged funds such as index funds generally have the lowest fees since they don’t have a team of managers to pay, a research department, and so on.  When choosing which fund to buy, choosing the one with the lowest fees is usually the best option.  In general, ignore their past returns.  Buying a fund that has done really well in the past may mean that you’re just buying in at the top.

What do I need to do to maintain the portfolio?

In general, there is nothing you need to do after you buy in.  If you’re investing regular amounts, just keep buying as you raise money, purchasing whatever is needed to keep your funds in balance based upon your chosen allocations.  For example, if you want to have 80% stocks and 20% bonds and bonds have risen such that you’re 30% in bonds, direct new money towards stocks.  If things get really out-of-whack you can move money between funds, but you’ll need to pay taxes on any gains for the shares that you sell unless the portfolio is in a tax-sheltered account such as an IRA or a 401K.

Speaking of taxes

If you’re investing in a tax-sheltered account, there are no tax concerns until you start taking the money out.  If you’re in a taxable account, you’ll need to keep track of gains and losses when you sell shares and add them to your income tax forms.  It is best to see an accountant for this since a good accountant will also give you tips on how to minimize taxes, although I’m sure tax software can probably handle most things.  In general, you’ll not want to sell very often in a taxed account, although realize that a small move int he markets can quickly wipe out any tax savings, so don’t let fear of taxes drive youinvestinggn decisions.

To ask a question, email vtsioriginal@yahoo.com or leave the question in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

 

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